Debt-to-income ratio for mortgages

Unpacking one of the most important factors for getting the right mortgage

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Buying a new home is exciting, but the process can be confusing and filled with unfamiliar terms. Along the way, your debt-to-income ratio (DTI) will likely be mentioned several times.

Your DTI is the percentage of your monthly income devoted to paying debts. Mortgage lenders use this ratio, in part, to determine your ability to repay a loan.

What is the ideal debt-to-income ratio for a mortgage?

A low DTI means you have a good balance between debt and income, so a lower percentage increases your chances of approval.

In general, 43% is the maximum debt-to-income ratio that mortgage lenders will accept. However, an ideal front end ratio is 28% and 36% is ideal for a back end ratio.

Why is the DTI ratio so important for mortgages?

When lenders issue any type of loan, there’s always a risk of the borrower defaulting, so your interest rate is essentially a premium for the lender’s assumed risk. If you have a high DTI, it means that a good portion of your earnings already goes towards debts, which could affect your ability to make mortgage payments. Before your application is approved, lenders evaluate your DTI to determine your ability to repay the loan.

The five C’s of credit

Lenders may use the five C’s of credit to evaluate your application: capacity, capital, character, collateral and conditions. The DTI is a key part of this process, as it reflects each component of the evaluation:

    Capacity. Since your DTI ratio reflects the amount of your income that goes toward debts, it demonstrates your ability — or capacity — to take on a mortgage.

    Capital. Otherwise known as a down payment, capital is the amount of money you’ve invested in the property. A low DTI ratio may allow you to make a larger down payment.

    Character. Your debt-to-income ratio shows your propensity to save and use credit responsibly, which are a reflection of your character as a borrower.

    Collateral. This show the lender if you have other properties or assets to use as collateral.

    Conditions. The principal and interest rate of your loan affect your chances of approval. A low debt-to-income ratio may help you secure more favorable conditions.

What are the debt-to-income ratio guidelines for mortgages?

There are two ways a DTI can be calculated:

  • Front-end ratio: The percentage of income that goes toward housing costs. It’s calculated by dividing either your monthly rent or PITI (principal, interest, taxes and insurance) by your gross monthly income. Aim to keep this number under 28%.
  • Back-end ratio: The percentage of income that goes toward recurring debts — including rent or PITI — calculated by dividing the sum of all debts by your gross monthly income. Aim to keep this number under 36%

Case study:

For example, say you make $4,000 per month and spend $400 on a monthly car payment, $400 on your credit card bill and $800 on rent. This gives you a front-end DTI of 20% and a back-end ratio of 40%.

There’s a good chance you would be approved for a qualified mortgage, but the rate you’ll get depends on your lender’s preference for a front- or back-end ratio. While your front-end ratio falls under the 28% cutoff, you might not get the best rate since your back-end ratio exceeds the lender’s preference of 36% or lower.

MUST READ: The qualified mortgage rule.

A qualified mortgage is a type of home loan that’s designed to be fair to borrowers. Lenders issuing this type of loan must meet certain requirements to ensure that you have the ability to repay the mortgage.

Some of these requirements include prohibiting certain risky loan features or excess points and fees. And most importantly, a debt-to-income ratio below 43%. However, qualified mortgage requirements don’t apply if you’re eligible to purchase through Fannie Mae, Freddie Mac or the FHA.

How can I improve my debt-to-income ratio?

If you’re having trouble getting approved for a mortgage or just want a better rate, there are a few ways to improve your DTI:

  • Pay off debt. The simplest way to lower your DTI is to reduce your debt. You can do this by paying down your current debts faster — which will raise your DTI initially, but significantly reduce it in the long run.
  • Postpone large purchases. If you know you’ll be applying for a mortgage soon, try to postpone any large purchases, as they’ll increase your DTI.
  • Refinancing. Refinancing high-interest debts reduces your interest rate, meaning more of your money goes towards the principal and the debt will be paid off sooner.
  • Increase your income. A part time job, raise, or any other increase to your monthly earnings reduces your debt relative to your income.
  • Consolidate. If you have debts, consider consolidating to reduce your monthly minimum payment.

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Bottom line

Your debt-to-income ratio is an essential measure that lenders consider when you apply for a mortgage. Whether you’re currently home shopping or preparing for the future, use the DTI calculator to find out where you stand.

Once you’re ready to apply, shop around and compare home loans to find the best option for your situation.

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